3 Extent Decisions and Investment Decisions

3 Extent Decisions & Investment Decisions - Should you increase the quality of your Examples of Extent Decisions - How much labour to hire? - How much inventory to hold? - Is your workforce big enough or small? - Should you change the level of service? advertising? - How safe should you make your work environment? Marginal Analysis • To analyse extent decisions, we break down the decision into small steps and calculate the costs and benefits of taking another step. • If the benefits are greater than the costs, then take another step, otherwise step backward. • The analysis tells you the direction of change but not the distance which comes from experimentation. • This is because marginal cost typically rises and marginal revenue falls with additional steps so after taking a step, you have to calculate marginal cost and benefit to see whether the further steps are justified. Marginal Cost Definition: The additional cost to make and sell one additional unit of output. Marginal Revenue Definition: The additional revenue gained from producing and selling one more unit of output. • Since revenue is how much money the extra unit brings in, marginal cost is the extra money you would have to pay towards costs after producing one more extra unit. Marginal = Price x Quantity Revenue Profit Maximisation • Profit = Total Revenue - Total Costs • Profit maximisation occurs when there is the biggest gap between total revenue and total costs. • If a firm produces less than Q1, MR is higher than MC, so producing an extra unit brings in more marginal revenue than costs which increases total profit. - If the benefits of selling another unit (MR) are bigger than the costs (MC), then sell another unit. - Just before Q1, MR is only just greater than MC, but the firm is still increasing total profit. - After Q1, the marginal cost of the output is greater than the marginal revenue. - This means the firm will see a fall in its profit level because the cost of these extra units is greater than revenue. - Therefore, profits are maximised when MR = MC because it allows firms to make supernormal profits and total profits peak at their highest point. • Profit = Price - Average Cost per unit Explaining Investment Decisions on a Diagram • At low levels of output, marginal cost tends to be lower than average cost. • Average costs decrease while marginal costs are lower than average costs. • But when marginal costs rise above average costs, average costs increase. • Marginal costs and marginal benefits are what matter in extent decisions. • Average and fixed costs are not relevant. • If we change fixed costs, it does not affect marginal costs or marginal revenue so it doesn’t affect the profit maximising level of output. Total Costs TC = FC + VC TC = FC + (MC x Q) When Q is equal to 0 TC = FC TC = FC + MC Q Q Total Costs = FC + VC = FC + VC Q Q Q Q Variable Costs VC = MC x Q Average Cost Average Cost = Total Costs Quantity AC = FC + MC Q Law of Diminishing Returns • As you start to pack more and more people in a factory, reach a point where people fall over each other. - Eg. Having to share resources, machinery, machines available not enough people to operate them. - Operate less efficiently as you try to increase output in a certain factory. Learning by doing Return • When we start to do something from a low-level, as we start to produce more we get better at it by learning, so start to get more efficient. - As long as marginal cost is below your average, it’s pulling average costs down. - As soon as marginal goes above average, it’s pulling your average up. • Managers have to decide between competing strategies to achieve the same end. - If you don’t have information about marginal revenue, marginal analysis can still be used to compare the marginal costs of alternatives - Eg. Choosing between types of advertising requires looking at the opportunity cost of choosing the next best alternative. - To increase profit, increase spending on whichever medium has a higher marginal effect, shift the spending to reduce on one method and increase on another. - This would increase profit even if you don’t know what the marginal benefit is. • You should make changes one at a time so you don’t lose the valuable information about the marginal impact of each change when you change both at the same time. - By changing them separately, you can measure the marginal effectiveness of each. Problems • It is difficult to measure the margin cost and benefit of an additional step. Customer Acquisition Cost • The business’ best estimate of the marginal cost of acquiring another customer. - If the marginal benefit is more than the marginal cost, go ahead with further steps. Incentive Pay • Marginal analysis can be used to design incentives to encourage hard work. • Shirking: When sales forces respond to the smaller marginal benefit of selling with less effort. • To induce higher effort, use incentives that reduce marginal costs or increase marginal benefits. • Fixed costs and benefits do not change effort. • It is difficult to know when it is best to implement incentive pay especially in jobs where it is difficult to measure performance. • Incentives schemes are most effective when there is little intrinsic desire to do the job and the money boosts the recipient’s social status. Problems • Incentive pay can lead to inequality among workers. - If you reward productivity, more productive or hard working workers will get paid more. - However, incentive pay schemes expose workers to risk beyond their control such as the unpredictable consequences of a dynamic economy affecting a salesperson’s sales. - These schemes confuse the fact that everyone has equality of opportunity but not the same equality of outcome which leads to greater inequality but people can see as ‘unfair’. - People are reluctant to accept this trade-off so it can be difficult for a firm to raise productivity. Investment Decisions • Investment decisions are a type of extent decisions but look into the future. • All investments represent a trade off between possible future gain and current sacrifice. • Make decisions that have a time dimension through backward induction. - This involves looking at where you want to be, work back to where you are now to see if the investment decision is beneficial to the business. Compounding & Discounting • All investment decisions involve a trade off between current sacrifice and future gain. • Before investing, you need to know whether the future benefits are bigger than the current costs. • Discounting helps you figure this out through compounding. Compounding Formula (future value, k periods in the future) = (present value) x (1 + r)k r = rate of return If you invest at a rate of return r, divide the time (x) by r to get the number of years to takes to double your money. Low Discount Rate • Individuals with low discount rates would willingly lend to those with higher discount rates. • People with money lending money out for a low rate. • You have a high discount rate by being willing to borrow at a rate that is higher because you have an idea that you think will yield a high return quickly. • Therefore, the higher discount rate represents a higher value of money. - Eg. Starting a business enterprise, investing in a profitable business. - Lower discount rate = Less patient because you put a lower value on the future. Discounting Formula (Net Present Value) • X = Change in cash flow each period. • R = Interest rate • Present value of cash flow = Ignoring the cost (X0) • If the Q is asking for NET present value, then take into consideration the X0 NPV = X0 + X1 + X2 + X3 1 + r (1 + r)2 (1 + r)3 0 = Now (cost) 1 = 1 years time 2 = 2 years time 3 = 3 years time Determining whether Investments are Profitable • Discount the future benefits of an investment and compare them to the current cost of the investment. • If the different is positive, the investment earns more than the cost of capital. • Companies have discount rates determine by the cost of capital. • A company’s cost of capital is a blend of debt and equity - it’s weighted cost of capital (WAAC). • Time is a critical element in investment decisions. • Cash flows to be received in the future need to be discounted to the present value using the cost of capital. NPV Rule • If the net present value of discounted cash flow is larger than zero, the project earns more than the cost of capital. NPV & Economic Profit • Projects with a positive NPV create economic profit. • Only positive NPV projects earn a return higher than the company’s cost of capital. • Projects with negative NPV may create accounting profits, but not economic profit. • In making investment decisions, choose only projects with a positive NPV. Break Even Analysis • If you can sell more product than the break-even quantity, the entry is profitable. • (P-MC) is the contribution margin - what is left after marginal cost to contribute to covering fixed costs. Fixed Cost (F) Break Even Quantity (Q) = (Price (P) - Marginal Cost (MC)) Choosing the Right Manufacturing Technology • Do not resort to break even analysis to justify higher prices or greater output. • Mangers often think they must raise price to cover fixed costs. • They think since average costs decline with quantity, they must sell as much as they can to reduce average costs. • Pricing and production are extent decisions that require marginal analysis, not break even analysis. Shut Down Decisions & Break-Even Prices • If you shut down, you lose your revenue but you get back avoidable cost. • If revenue is less than avoidable cost or if price is less than average avoidable cost then shut down. Sunk Costs & Post-Investment Hold-Up • Because sunk costs are unavoidable, even in the long-run, if you make sunk cost investments, you are vulnerable to post-investment hold up. • The hold up problem occurs when a business must incur a sunk cost in order to fulfil its side of a business deal. • If one party makes a specific investment that is sunk or lacks value outside the trading relationship, the party can be held up by its trading parter in the form of re-negotiating • • • • - the terms of the deal by asking for a lower cost of producing a product specific to that business. Eg. Since the Economist magazine is a different sized magazine to any other, the printing company must make an upfront investment to adapt its presses to print The Economist. This makes the presses useless for printing any other magazine. Consequently, once the sunk cost is payed, businesses know they can’t get this money back if the business relationship with the Economist comes to an end. Once the Economist realises the printing firm has made a sunk investment to print its magazines, the Economist can demand a lower price for its services. The printing firm and the Economist had initially negotiated a price per magazine that would enable the printing firm to cover the cost of its upfront investment. To break-even, the price negotiated must be equal to P = AC = FC/Q + MC. But once the cost of the investment is sunk, The Economist can demand a lower price of P < AC. The Economist has the incentive to hold the printer up in this way because any loss that it forces onto the printer translates into increased profit for the Economist. As the printer firms service has no value outside the specific relationship, the Economist can use that to renegotiate terms to lower the cost for the business. Because the investment would be specific to the relationship with that client, you can’t take the work done and sell it to someone else. Avoiding Post Investment Hold-Up • A firm can anticipate the hold up problem by thinking carefully whether it is making any RELATIONSHIP SPECIFIC INVESTMENTS as part of a business deal. • This is where the investment has value within a specific business relationship but not outside it making it a sunk cost. • If one party anticipates the risk of being held up, they will be reluctant to make relationship specific investments or demand costly safeguards such as compensation in the form of better terms from her trading partner. • This gives both parties an incentive to adopt contracts such as investments in reputation, merger to reduce the risk of holdup. • The goal is to ensure both parties have the incentive to make relationships specific investments and to trade after these investments have been made. • Look ahead and reasoning back can help you avoid potential hold up. • Before making a sunk cost investment, ask what you will do if you are held up? • What would you do to address the hold up? • A good way of spotting when sunk costs are going to happen is asking the business whether they can take the work done and sell it to someone else? Solutions 1. Separation of Contracts • This would involve writing a separate contract for each part of the transaction. • This ensures sunk costs are paid in a different contract to the work carried out which stops the other party being able to re-negotiate the terms of the deal. - Eg. Printing firm writing one contract with the Economist to adapt its presses and the second contract to print the magazines so the Economist cannot hold up printing. 2. Vertical integration • This is where the firm making the relationship specific investment buys the other firm. • Then the losses incurred from hold up would be taken into account by the new combined firm and it would no longer have the incentive to create them. - This would maximise profits overall rather than compete against each other if working together. • This is not always possible due to time taken to merge/acquire firms and costs that come with merging.